Portfolio Managers Forecasted Returns Explained

[Michael Episcope]

(Updated version for all BiggerPockets members to enjoy.)

If one portfolio manager forecasts a return of 20% on a real estate investment and another one forecasts a return of 15%, which one is the better choice?

Answer: It depends on several factors.

With hundreds of real estate deals to choose from, how do you make the right investment choice? The term "risk adjusted return’" means literally that. Returns have to be adjusted for the level of risk to accurately compare them to one another. A 10% return may, in fact, be better than a 20% return, once certain risk factors are taken into account. The question every investor needs to ask is, what unit of risk is one taking to achieve each unit of return? In short, the larger the risk, the larger the expected reward.

If a fund achieves a 15%return with half the risk of a fund that returned 20%, then the fund that returned 15% has achieved a far better risk adjusted return. An investor needs to consider this in each and every investment made, as the law of large numbers eventually will come into play. You can certainly get lucky once or twice but good decision making is the key to long term success.

Every real estate investment has its own risk-reward profile. I suggest looking at five types of risk as a starting point to judge any real estate investment.

Real Estate Risk Categories to Assess When Investing

1. Leverage risk

Borrowed money is a risk-reward magnifier.

In commercial real estate, risks and rewards rise with the amount of debt used to buy and improve a property. Projects that are capitalized with more debt should, in general, be projecting a much higher return on equity. A project that uses 70% leverage is more risky than one that uses only 50% leverage, and you should get paid for this risk. I’ve seen projects levered up to 90% that offer the same returns as a project that is 65% levered. In this case, the sponsor is taking excess risk to achieve an average return. This is a bad deal for the investor no matter how you slice it.

To really compare two investment opportunities, strip out the debt and then compare them on what’s known as an unlevered basis. Generally, the one with the higher unlevered return is going to provide the better risk-adjusted return once debt is applied.

Leverage can be a valuable tool in real estate investing but needs to be used wisely. Run away from situations where the debt is high but the returns are average. Preferred equity and Mezzanine debt also need to be taken into consideration, and the terms of the debt should match the business plan of the asset. If a property had debt that matures in 5 years and a tenant that is scheduled to vacate in 6 years, then the sponsor needs to have a very good explanation for how they plan on refinancing the asset. What happens if they cannot renew the tenant?

2. Asset-type risk

Hotels, apartment buildings, senior living facilities and retail centers all have different risk characteristics. An apartment building relies on tenants who sign annual leases while a hotel relies on overnight and often seasonal business. A healthy economy contributes to the success of both but to different degrees. Apartment operating income historically has been much more stable than that of hotel income. Apartments also tend to be more of a pure real estate play while hotels and senior living facilities are less about the real estate and more about the service and operations.

In general, apartments tend to be less risky and investors can accept a lower nominal return on an apartment building while still achieving the same risk adjusted return, with all else being equal.

3. Project-level risk

Similarly, ground-up development has a much different risk profile than a building that has existing cash flows with tenants in place.

That doesn’t mean you should avoid ground-up development. Quite the contrary. But when doing such deals, make sure you are being fairly compensated for the additional level of risk.

A ground-up apartment building using 75% leverage may, in fact, be less risky than a stabilized hotel that uses only 50% leverage. All three factors need to be taken into consideration when evaluating any opportunity.

4. Fees

I am not a believer in finding the lowest-cost provider when it comes to investing in real estate. However, certain fee structures should be avoided altogether and tell a story about the sponsor. Non Traded REIT's are notorious for egregious fee structures. They typically take 15% to 18% off the top. What this means is that the investor is down 20% on day one.

Real estate is an actively managed asset class and one invests privately to generate excess returns above the benchmark. Top quartile managers are worth their weight in gold and bottom tier managers are not worth a look, no matter how little they charge. Hiring a real estate investment manager—and that’s what you’re doing when you make an investment—is no different from hiring an employee: You want the best person possible in that job and you want to pay them a fair price for their contribution. A top quartile manager can double your investment, while a bottom quartile manager may suffer an entire loss.

5. Sponsor

I’ve saved the most important consideration for last because this kind of goes without saying. WHO you invest with is undoubtedly the most important variable to consider in any real estate investment. Spend time underwriting the sponsor and make sure they have a team that can execute and that their goals are aligned with your goals. Is the performance of the investment their top priority or are they in the business of aggregating assets and creating fee streams for themselves? What conflicts do they have internally? What is their track record? Always ask about their worst deal and how they handled it. What did they learn? As a final step, ask for references and not just the ones they want to give you. Ask them to supply a reference from an investor with the first name starting with “John” or “Michael,” and see what they say. If they value you as a potential partner and they have nothing to hide, it shouldn’t be a problem.

One additional word of advice is to not spread your capital around to 20 different managers. This will only help you achieve marginal returns and doesn’t diversify your risk. True Alpha will only be achieved by 25% of all managers, so spend the majority of your time vetting the manager rather than the deal. This is something that pension funds and endowments learned years ago.

One thing you can be certain of when reviewing any deal, is that the pro forma is wrong. Don’t get caught up in the projections. If you protect the downside, the upside takes care of itself. I strive to buy great assets at the right price and maximize investment performance by improving operational performance, not through financial engineering. I won’t always win the marketing battle of showing outrageous returns to attract investors, but I believe in my process. My goal is to promise only what I know I can deliver and I believe this is the best way to achieve long term for success for me and my partners.